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The Proposal for a Directive on Alternative Investment Fund ...

  1. 1. The Proposal for a Directive on Alternative Investment Fund Managers June 2009
  2. 2. This Briefing Paper is an edited version of a presentation given by Kirstene Baillie, Head of the Financial Services and Funds Group, of Field Fisher Waterhouse LLP at a seminar on the Proposal on 3 June 2009. The Proposal is rapidly developing and, for up to date comment and advice, please contact Kirstene Baillie or your usual contact at Field Fisher Waterhouse LLP. The momentum for more regulation of alternative investment fund managers has been gathering for some time and is now probably unstoppable. Ideally any such initiative should be on a global basis, because it relates to a global industry, but the recently published European initiative will no doubt progress regardless. All agree that the Commission’s Proposal is flawed – indeed it has caused considerable consternation. The Proposal contains a number of particular management and fund structuring requirements which may not fit easily with existing alternative investments fund structures. Ironically, given that the Proposal is aimed particularly at hedge funds, one result may be to drive hedge fund managers to operate from outside the EU, which could be to the detriment of the UK fund management sector, given that most European based hedge fund managers are based in London. For non-UCITS fund managers in the EU, there could potentially be serious implications. Retail fund managers may be directly affected if the coverage remains all non-UCITS funds. In addition, some of the proposals put forward for alternative investment funds could in due course be proposed for UCITS funds too — it would certainly be illogical for there to be more onerous provisions for alternative investment funds for professional investors than for UCITS funds for retail investors. So the Proposal is relevant to a very wide range of investment funds and their managers. Causes, and objectives targeted requirements. Some concerns are linked to behaviour, such as short selling, use of stock borrowing or other instruments to build a stake in a The Proposal asserts that, while AIFMs were not the company. The intention is to apply comprehensive cause of the crisis, recent events have placed measures to all market participants who engage in severe stress on this sector. The risks associated such relevant activities (although one wonders with their activities have manifested themselves whether they have in fact identified the right throughout the AIFM industry over recent months constituent audience). It is acknowledged that and may have contributed to market turbulence. some of these issues will form the focus for a review of relevant existing EU Directives. This new The Commission’s Proposal identifies a number of Proposal is however designed to address matters perceived risks which currently exist. These focus that call for provisions specific to AIFMs and their on: businesses. • macro-prudential (systemic) risks This Proposal aims: • micro-prudential risks • to establish a secure and harmonised EU • investor protection framework for monitoring and supervising the • market efficiency and integrity risks that AIFMs posed to their investors, counterparties, other financial participants and • impact on market for corporate control; and to financial stability; and • impact on companies controlled by an AIFM. • to permit, subject to compliance with strict The Proposal focuses on those activities that are requirements, AIFMs to provide services, and market their funds, across the internal market. specific or inherent to the AIFM sector, clearly concentrating on the hedge fund and private equity sectors, and hence need to be addressed by 2
  3. 3. The difficulty though is that regulation will not provide an answer to many of the key problems: However, before investigating the Proposal, let’s though destroy three fallacies: − If a fund holds an illiquid asset, we cannot • First, let’s state what should be obvious. One make the fund’s assets liquid by regulation. cannot solve much of what has recently gone For a property fund, for example, there has on by regulation. Regulation is not the been a somewhat false sense of security answer. created by having open ended real estate funds, where one claims there is regular It is thought that the financial regulatory and dealing but in fact this cannot be delivered supervisory system aided and abetted the super- if there are few property assets and those bubble, although it did not itself cause the crisis: property assets cannot promptly be sold at a fair value, or at all. Funds of hedge “As the De Larosière Report, …. states: ‘Liquidity funds give a similar issue – diversification and low interest rates have been the major may help but can only partially help, and underlying factors behind the present crisis, but there may still be a case where the financial innovation amplified and accelerated the underlying hedge fund investments cannot consequences of excess liquidity and rapid credit be realised quickly. expansion’. − To take valuation, this is not an exact While our regulation was not the root cause, our science and never has been. For a private financial regulatory and supervisory system aided equity fund, for example, one cannot, just and abetted this super-bubble. It did not stem the by having valuation guidelines and some flow of leverage through the financial system. It form of independent valuation, make the allowed the emergence of business models based valuation of the fund’s unlisted securities on flimsy and highly leveraged foundations. It magically correct and reliable. tolerated relaxed lending practices and the accumulation of unsustainable debt by household, So when reviewing the details of the Proposal we individuals and companies. It facilitated the should also bear in mind that regulation of the gaming of prudential capital requirements. And it fund structure and the fund managers will not alter has exacerbated the depth of this crisis because the position on these basic issues. of the pro-cyclical effects of some of its key provisions. • Secondly, given that the main target of the Proposal is hedge fund managers, it should be But let us be honest with ourselves and – more noted that it is generally agreed that lack of importantly – with our citizens. We shall not regulation of this sector was not a cause of a regulate ourselves out of this crisis. Fixing real problem in the current crisis. regulation and supervision will not extract us from As commented in the De Larosière High Level the present mess. But we must draw the Group Report on Financial Supervision in the EU, consequences from today’s crisis and take published 25 February 2009 (Point 86, page 24): action … “Concerning hedge funds, the Group considers We are now at the stage where we need to they did not play a major role in the emergence of examine what further measures might be the crisis. Their role has largely been limited to a warranted. Our aim is to put the financial system transmission function, notably through massive back on a more secure and sustainable footing. selling of shares and short selling transactions. And to prevent a recurrence of recent catastrophic We should also recognise that in the EU, unlike events.” the US, the great bulk of hedge fund managers are registered and subject to information Extract from opening speech of Charlie McCreevy, requirements. This is the case in particular in the European Commissioner for Internal Market and UK, where all hedge fund managers are subject to Services to the EC Conference on Private Equity and Hedge Funds (Brussels, 26 February 2009) 3
  4. 4. registration and regulation, as all fund to the EC conference on private equity and managers are, and where the largest 30 are hedge funds in February: subject to direct information requirements often obtained on a global basis as well as to indirect “Closer, direct regulatory and supervisory monitoring via the banks and prime brokers.” oversight of hedge funds and private equity is inevitable. As I said earlier, we need to be It is generally agreed that, of course, there have careful in designing regulation that is effective – been consequences for them, and some of not counter productive … them may have been a peripheral contributory factor - but they are probably not a central In framing our response to the crises, I want to cause. Perhaps certain consequences could move quickly where this is necessary and have been alleviated if investment fund justified. At the same time, we need to continue structures had had better processes in place to carefully evaluate and measure any sooner. proposals we bring forward. Regulation is framed in stone. I want us to get it as right as The March 2009 IOSCO Consultation Report we can, because undoing it afterwards is well on Hedge Funds Oversight identified that the nigh impossible.” inherent risks relating to the activities of hedge funds and their managers are primarily as a Extract from concluding remarks of opening speech of result of two factors: Charlie McCreevy to the EC Conference on Private Equity and Hedge Funds (Brussels, 26 February − lack of transparency regarding the funds 2009) to investors and other market participants, such as counterparties and Given that we should assume that regulation is regulators; and coming, the task is to lobby to try to make it sensible new regulation. There is a concern − conflicts of interest between fund that the new Proposal has been rushed out in managers and other market participants, the light of recent events, responding to the particularly regarding managers’ considerable political momentum gathering in remuneration. favour of more regulation. There is concern that the Alternative Investment Fund Managers These risks can be amplified by poor systems Directive has been rushed. and controls. Indeed, in many cases where issues have been found regarding the activities Indeed the published Impact Assessment of hedge funds or their managers, there have accompanying the Proposal states that the also been problems with the control Board acknowledges that the preparation of the environment. Report has been affected by the tight schedule for adoption of the proposal as part of the Bad systems and controls have meant that Commission’s response to the financial crisis, people have found out too little too late about and this has had a significant impact on the hedge funds and their operations – and by quality of the Report: people, I mean both investors and regulators. But do the proposals address these concerns? “The draft provides only a partial analysis and • Thirdly, and despite the first two points, significant further work needs to be done”. more regulation is inevitable – the task is to make it good regulation. One might be concerned that such partial analysis may have led to proposals for a partial That new regulation will be introduced is very solution with significant failings. clear from the concluding remarks in the opening speech of Charlie McCreevy the EU However considerable background work has Commissioner for Internal Market and Services been undertaken. The new regulations do not 4
  5. 5. come out of the blue . What is new though is any assets acquired through use of leverage, that the important authorities have now decided which in total do not exceed a threshold of €100 that a formal proposal should be advanced. million or, when the portfolio of the alternative investment fund consists of funds that are not It is therefore clear that the Commission takes the leveraged and with no redemption rights view that the time for self regulation is over and the exercisable during a period of five years following time for sensible and co-ordinated regulation has the date of constitution of each authorised come. investment fund, €500 million. The Commission consider that this Proposal will cover 30% of hedge fund managers, managing Key proposals about 90% of the relevant assets. • managing all manner of non UCITS funds So what is proposed? And is it sensible? Let’s consider the key proposals which are now put It applies to fund managers managing non UCITS forward in the Commission’s Proposal for a funds - or to take another new piece of jargon Directive on Alternative Investment Fund “NHF” or “non harmonised funds”. Perhaps the Management. Directive should be renamed to make this clear. (When reviewing the details please ensure that you The Proposal gives a very wide definition of have regard to the specific terminology which is alternative investment funds to cover, for example: adopted in the Directive. For your assistance the hedge funds, private equity funds, property funds, Appendix to this Briefing Paper sets out various of and covers both open and closed ended collective the key terms, taken from some of the explanation investment schemes. of the acronyms from Annex 1 of the Impact Assessment for this Proposal for a Directive, and Possibly the scope is too wide. The Commission then comments on how they fit with the usual indicates that they will cover a whole range of non definitions and interpretations to which we are UCITS retail funds authorised in EU member states accustomed in the UK.) and funds from offshore centres (one hopes including most hedge funds). Consider, for The Proposal identifies various high level objectives. example: To identify the basic proposition: − some retail but non UCITS funds are caught. Why should UK NURS funds be • there should be regulation of a wide range of covered by a Directive which is aimed at fund managers funds to be made available to professional First, note that it aims to apply to fund investors? managers rather than funds. This is not entirely and true because there is a certain coverage of fund issues (for example relating to leverage, on − some funds which are subject to a which see below) and providing a fund passport completely different style of regulation are (on which, again, see below) but essentially it is apparently included, such as British covering regulation of alternative fund investment trusts which are listed managers. companies, but which now seem to be viewed by the Commission as closed ended The aim is to regulate the larger managers. collective investment undertakings. Smaller ones are excluded from the scope of the Directive although they can opt in. There Ironically, whereas many of those funds which are are excluded managers who manage portfolios well established in the EU will need to cope with whose assets are under management, including new regulation if indeed the Directive is to encompass them, the real target for the Directive – 5
  6. 6. hedge funds – may well, if they do not like the − act honestly with due skill and care and regulation, seek to move outside the EU and so diligence and fairly in conducting its escape regulation. activities; • with regulation governing fund managers’ − act in the best interests of the Fund it resources and activities in respect of those manages, the investors of the Fund and funds the integrity of the market; and In some ways, the regulatory proposals seem − ensure that all the Fund’s investors are to build on existing European funds regulation treated fairly. No investor may obtain and, in particular, there are signs that it builds preferential treatment unless this is on the existing UK regulatory position for the disclosed in the Fund’s rules or instrument structure of an investment fund and the of incorporation. regulation of fund managers. Whilst therefore many of the areas for regulation will seem quite These do look rather familiar to UK lawyers. Of familiar to UK based readers, as a package particular interest is the second one which they are, for the reasons explained below, requires a Fund Manager to act in the best thought to be seriously flawed as proposed. interests of investors, which is very much old unit trust based related but can often be relied upon This wide coverage may conceivably work if the for providing a sound fundamental principle. emphasis is truly on the management by fund managers rather than specific investment issues • capital resources requirements and issues relating to the structure of the funds. Certainly the emphasis is on authorisation for the A Fund Manager covered by the Directive must fund manager. More detailed review of the precise have own funds of at least €125,000. Also, where proposals though, reveals a somewhat more the funds under management in its fund portfolios complicated picture, with some proposals affecting, which it manages exceed €250 million, the Fund and/or having the potential seriously to affect, both Manager shall provide an additional amount of fund managers and the funds which they manage. own funds which is equal to 0.02% of the amount by which the value of the portfolios of the Fund In the following paragraphs, we seek to draw Manager exceeds €250 million. This calculation out the key proposals so that you can form your is by reference to portfolios managed, even if own view as to whether these might, subject to there has been further delegation of one or more some redrafting and some specific changes, be functions, and includes the value of any portfolios made to work and form a cohesive package. which the Fund Manager manages under a delegation. Irrespective of these requirements, • general principles for fund managers the own funds of the Fund Manager shall never Article 15 states general principles that the be less than the amount required under Article 21 Alternative Investment Fund Manager shall at of the Directive 2006/49/EC of 14 June 2006 on all times use adequate and appropriate the capital adequacy of investment firms and resources that are necessary for the proper credit institutions (recast), i.e. one quarter of their performance of their management activities. preceding year’s fixed overheads. Specific concerns are then also addressed: They shall update systems, document internal procedures and have regular internal controls Notably: of their conduct of business, in order to mitigate and manage the risks associated with their • Management and disclosure of conflicts of activity. interest The general principles of article 9 state that the In Article 10, a Fund Manager must take all Manager shall: reasonable steps to identify conflicts of interest between the Fund Manager including their 6
  7. 7. managers, employees or any person directly or the investments comply with the underlying indirectly linked to the Fund Manager by control, obligations. There must be regularly conducted and the investors in the Fund or between one stress tests both under normal and exceptional investor and another that arise in the course of liquidity conditions and monitoring of the liquidity managing one or more Funds. There must be risks. How the Fund Manager must ensure that effective organisation and administrative redemption policies are appropriate to the arrangements with a view to taking all liquidity profile of the investments for the reasonable steps designed to prevent conflicts relevant Fund. from arising which may adversely affect the • additional operational and counterparty risks interests of a Fund and its investors. The Fund associated with short selling Manager must segregate, within its own operating environment, tasks and There is specific mention, for fund managers responsibilities which may be regarded as engaging in short selling on behalf of a Fund, incompatible with each other – and material that Member States must ensure that the fund conflicts of interests in its operating conditions manager operates procedures which provide it must be disclosed to Fund investors. Where with access to the securities or other financial management of conflicts may not be sufficient instruments at the date when the fund manager to ensure that risks of damage to investors’ committed to deliver them, and that the fund interests are prevented, there must be clear manager implements a risk management disclosure of the general nature or sources of procedure which allows the risks associated conflicts of interest to investors. with the delivery of short sold securities or other financial instruments to be adequately • satisfy competent authority of robustness of managed. internal arrangements with respect to risk management As you can see, these points concern Fund Article 11 aims to ensure that the functions of Managers but will, in fact, affect not just the Fund risk management and portfolio management are Manager’s arrangements in respect of their Funds separated and subject to separate reviews. A but also the documentation for the Fund itself. Fund Manager must implement risk management systems in order to measure and There are some interesting proposals for some monitor appropriately all risks associated with of the parties involved with the funds and how each Fund’s investment strategy and must they may delegate their responsibilities (or not). review the risk management systems at least For each of the Fund Manager, valuer and once a year and adapt them whenever depositary, there are various new measures to necessary. There must be an appropriately consider regarding delegation. Each of these needs documented and updated due diligence process some detailed working through – and they are likely when investing on behalf of the Fund; to mean that Fund Managers and identification, measurement and monitoring of risks associated with each investment position Depositaries will be particularly concerned to review of the Fund; and risk profile of the Fund and strengthen their agreements with generally shall correspond to the size, portfolio administrators, valuers and sub-custodians. structure and investment strategies and objectives set out in the Fund’s rules or • fair valuation of assets instruments of incorporation. The aim is reliable and objective valuation of • liquidity management assets. Liquidity management is the topic covered by Under Article 16 there must be a valuer Article 12. There must be an appropriate appointed which is independent of the Fund liquidity management system and procedures Manager to establish the value of assets adopted which ensure that the liquidity profile of acquired and the value of shares or units. 7
  8. 8. Valuation must be at least once a year and of the Fund for any losses suffered by them as a each time shares or units are issued or result of its failure to perform its obligations. In redeemed if more frequent. Rules applicable to the case of loss of financial instruments of which valuation of assets and calculation of NAV shall the depositary has safekeeping, the depositary be laid down in the law of the country where the can only discharge itself of its liability if it can fund is domiciled or in the fund’s rules or prove that it could not have avoided the loss instrument of incorporation. Implementing which has occurred. Any delegation to other measures will be expected to clarify the criteria depositaries will not affect this liability. for what is meant by independent. Considering the international nature of In relation to the appointment of valuers in a investments, delegation of depositary tasks in third country, the above requirements for respect of a fund domiciled in third countries is appointment of valuers must be fulfilled and accepted. Article 38 specifically envisages the also the third country must be subject to a appointment of a sub depositary domiciled in a decision by Commission implementing third country but there will be conditions. The measures stating that valuation standards and third country must be subject to a decision by rules of the third country legislation are the Commission and implementing measures equivalent to those applicable in the stating that prudential regulation supervision Community. and standards of the third country are equivalent – one wonders how this can be achieved in • Depositary’s increased role certain jurisdictions; there must be co-operation For each Fund, the Fund Manager must ensure between the home member state and the that a depositary is appointed to fulfil certain relevant authorities of the third country being tasks: sufficiently ensured; and the third country must be subject to a decision by the Commission − receive all payments made by investors stating that the standards on preventing money when subscribing for units or shares and laundering and other matters are equivalent to book them on behalf of the Alternative Community law. Note, further, that the Investment Fund Manager in a depositary’s liability towards investors would not segregated account (this is quite an be affected by any delegation to a third country interesting departure where the depositary. depositary in effect becomes the recipient of the cash rather than the fund This package of proposals for depositaries may manager); well be unrealistic. If implemented, it would likely have one or both of the following unhelpful − safekeep any financial instruments consequences: an increase in depositaries fees which belong to the Fund (much more and charges and/or a reduction in the number of common a role for a depositary!); and depositaries offering to provide such services. • delegation by the Fund Manager − verify whether the Fund, or the Fund Manager on behalf of Fund, has The proposals constraining delegation are also obtained the ownership of all of the a cause for concern. assets in which the Fund invests (again a role one would expect of a depositary). Where the Alternative Investment Fund Manager itself intends to delegate to third The depositary must be a credit institution parties, there will be certain conditions to be met having its registered office in the EU and – checking the credit worthiness of the third appropriately authorised. party and that they are of sufficiently good repute and sufficiently experienced. If there is Of interest to depositaries will be the specific delegation of portfolio management or risk statement in Article 17 that the depositary shall management, the third party must itself be be liable to the Fund Manager and the investors 8
  9. 9. authorised as a Fund Manager to manage a As you will expect, given the criticism of Fund of the same type. The delegation must operations of hedge funds, there is a focus on not prevent effectiveness of supervision by the transparency. Alternative Investment Fund Manager – and in • Improving transparency particular not prevent the Alternative Investment Fund Manager from acting, or the fund from A key initiative is to improve transparency both being managed, in the best interests of its to investors and to regulators. investors. The Alternative Investment Fund Manager must demonstrate that the third party − Article 19 will require an annual report for is qualified and capable of undertaking the each Fund which will need to be made functions in question; that it was selected with available to investors and regulators due care; and that the Alternative Investment within four months of the end of the Fund Manager is in a position to monitor Fund’s financial year. It will contain a effectively at any time the delegated activity; to balance sheet or statement of assets give further instructions to the third party; and to and liabilities; an income and withdraw the delegation with immediate effect expenditure account for the financial when this is in the interests of investors. year; and a report on the activities of the financial year. Note that no such delegation may be given by the Fund Manager to the Depositary, the valuer − For investors, there must be disclosure or to any other undertaking whose interests before they invest, and also of any may conflict with those of the Fund or its changes of certain key items identified in investors (these provisions mirror the existing Article 20. (The word “received” needs to UCITS Directive requirements in this regard). be changed to “sent” in the Directive wording because the obligation should One new point is that the third party may not be to send the information not to ensure itself sub-delegate any of the functions that each investor receives it.) delegated to it. The exact scope of this will need to be clarified. − In addition, there will be specific reporting obligations to competent The Fund Manager’s liability will not be affected regulators under Article 21. They will by the fact that the Fund Manager has need to provide aggregated information delegated functions to the third party and nor on the main instruments in which they shall the Fund Manager be able to delegate its trade; markets of which they are functions to the extent that, in essence, it can members or where they trade actively; no longer be considered to be the manager of and on the principal exposures and most the Fund. (This is an important point and would important concentrations of each of the effectively prevent any shell manager.) Funds they manage. For each Fund, there will be a periodic report to the Further, Article 36 deals with delegation by a regulator setting out the percentage of Fund Manager of administration to an entity in a the assets which are subject to special third country. This can only be achieved if the arrangements arising from their illiquid above requirements are fulfilled and also that nature; any new arrangements for entity is authorised to provide administration managing the liquidity of the Fund; the services or registered in the third country and is actual risk profile of the Fund; and the subject to prudential supervision and there is an risk management tools employed by the appropriate co-operation agreement between Fund Manager to manage the risks; the the competent authority of the fund manager main categories of assets in which the and the supervisory authority of the entity. Fund invests; and, where relevant, use of short selling during the reporting period. 9
  10. 10. Such tasks will also, of course, add to the expense fewer than 250 people with an annual turnover of fund managers in preparing such information but of less that €50 million and/or annual balance they may also assist a fund manager because sheet not exceeding €43 million. preparation of that information will focus its minds on the contents of the information and the issues There will need to be notification of acquisition behind that information. of controlling influences in non listed companies which are caught and disclosure in the case of These proposals will hopefully serve to educate acquisition of a controlling influence in issuers or both investors and regulators so that they can more non listed companies concerned. Where critically ask questions of the Fund Manager. The applicable, there will need to be specific corollary of this of course is that, in the event of provisions in the annual report of the fund. problems arising, the regulator will be expected to Again the detailed nature of these proposals be in a position to identify and require correction of need to be expanded upon in implementing failures promptly. measures – in particular the disclosure in the case of acquisition of controlling influence on Certain provisions apply to specific types of issuers or non listed companies to the issuer, funds. Aside from mention of short selling, the non listed company, their respective there are really only two investment strategy shareholders and representatives of employees specific proposals: or, where there are no such representatives, to the employees themselves. These are the two • Leveraged funds specific investment related proposals, aside For leveraged funds, there are additional from the risk management and disclosure issues requirements set out in Chapter V. Where a for short selling mentioned above and the Article Fund employs high levels of leverage on a 13 provision regarding investment in systematic basis, there must be disclosure to securitisation positions. investors of the maximum leverage and, on a quarterly basis, the total amount of leverage in The question is whether this Proposal should the preceding quarter. Further, there will be include any investment strategy specific reporting to regulators both of the overall level proposals. When dealing with the alternative fund sector, where one of the key objectives is of leverage and/or the breakdown of leverage to have a diverse range of investment arising from borrowing of cash or securities and propositions with freedom for managers to set leverage embedded in financial derivatives. them as they wish, it may seem somewhat inappropriate. Will the real target of this • Private equity funds Proposal - the offshore hedge fund sector - simply decide they do not wish to accommodate For private equity funds, there are specific the leverage requirement and remain outside additional requirements for fund managers the EU? managing funds which acquire controlling influences in companies set out in Section 2 of Chapter V. They apply where the fund manager manages a fund which, either individually or in aggregation, acquires 30% or more of the voting rights of an issuer of or a non listed company domiciled in the Community and the fund manager has an agreement which allows the fund to acquire 30% or more of the voting rights of the issuer or the non listed company, as appropriate. There are only excluded issuers or non listed companies which are small or medium enterprises employing 10
  11. 11. Main advantages for unregulated collective investment schemes which have been quite anachronistic of late. fund managers One would assume that these new arrangements will supersede the existing section 238 of FSMA and the COBS 4.11 Turning from the new requirements and their provisions. potential difficulties, let us look at the possible advantages for fund managers. • Consistent regulation • a fund manager passport The third advantage should be that the common approach to regulation to ensure consistency in The authorised fund manager itself will obtain a regulation but of course this will only be across passport under Article 34, in a similar way to the the EU. existing passports for insurance companies, banks and investment managers (and hopefully UCITS management companies). The passport could work on either providing management services directly or through a branch. Difficulties for offshore • a passport for marketing alternative investment tax haven domiciled funds to professional investors funds Also the authorised investment fund obtains its own passport. This is part of the odd mix in this There will be particular conditions to note for directive. The mix is therefore rather similar to marketing in the European Community of funds that available for UCITS funds under the UCITS domiciled in third countries – which of course Directive. There would be a passport so that apply to a vast majority of hedge funds, for there could be selling to investors in other EU example, established in the Channel Islands or member states who are professional investors the Cayman Islands. (as defined by MiFID). There will simply be a notification procedure pursuant to Article 33 – a The first point to note is the proposed three year simple notification process of submission of delay before the rights granted under the new documents to the home member state regulator directive to market such funds to professional which, no later than ten working days after investors will become effective so that appropriate receipt, should transmit the complete implementing measures can be devised. In the documentation to the other relevant EU state intervening period, member states may allow or regulators and, once done, the Alternative continue to allow (or perhaps not allow or continue Investment Fund Manager may start the to allow) fund managers to market such funds marketing of the fund in the other member domiciled in third countries to professional investors states as of the date of the home state notifying – it will be subject to national law. There is though a of this transmission. whole set of wider issues than simply the three year delay to consider. Note that, for retail investors, there may be differences because of different local legislation. Secondly, the draft directive only permits marketing of funds domiciled in third countries if their country Note also of course that, if there is any advice of domicile has entered into an agreement based on concerned, the MiFID requirements on Article 26 OECD Model Tax Convention with the suitability and appropriateness will apply in the member state on whose territory the fund shall be relevant Member States. marketed. The aim of this is purported to be that the national tax authorities may obtain all information One useful consequence though may be that, at from the tax authorities of the third country which are last, the UK may have to remove its historic necessary to tax domestic professional investors additional restrictions on promotion of 11
  12. 12. investing in offshore funds. The current deliberations regarding the OECD white list are So will this new however indicative of the problems which will arise. package of proposals There is a delegation issue too – for example for work? administrators and valuers because of the new delegation provisions explained above. Whether it will work depends on what you think The general overriding concern is that the approach can be achieved. taken in the drafting of the terms of the Directive The first major point to note is that this Directive is fails to accommodate the existing structure of only part of a wider set of initiatives. It cannot alternative investment funds – certainly in respect of entirely be viewed in isolation. Consider for hedge funds which are mostly established in tax example: havens with a corporate structure with a board of directors. Perhaps the thought is that the • abusive short selling may well be the subject of advantages of the coverage of the Directive and the proposals under the Market Abuse Directive - passports available will encourage EU domiciled the consultation ends on 10 June, and note the alternative funds – perhaps focused in FSA’s Consultation Paper 09/15 regarding Luxembourg? But is it not perhaps more likely that extension of the short selling disclosure the existing fund structures will remain in their tax obligation; havens for tax efficiency and flexibility reasons, and • there are proposed Recommendations on they will simply not take advantage of the Directive Remuneration on which separate proposals and its passporting options? There are some have now been put forward on 30 April and unanswered questions of what might happen if Member States are invited to take necessary funds do not come within the scope of the Directive measures to promote their application by 31 but will have EU based fund managers. If the worst December 2009; case scenario is that they simply do not benefit from • alternative investment funds will not be “non the passports, the Directive would have little effect. complex instruments” under MiFID (and that One therefore assumes that the intention is that the Directive is being amended). Coincidentally, Directive should be relevant for any alternative and in partial contradiction of this, CESR has funds (as defined) managed by EU based published a Consultation Paper dated 14 May investment managers. This though is not entirely on MiFID complex and non complex financial instruments for the purposes of that Directive’s clear from the drafting of the draft Directive. appropriateness requirements and there is a discussion, at paragraphs 85, which comes to The most probable target for the Commission is to the clear conclusion that “CESR believe that not capture all alternative funds managed from the EU. all UCITS should be regarded as automatically As most are in fact managed from the UK, UK non complex any UCITS or share in a non alternative investment fund managers will bear the UCITS collective investment undertaking can be brunt of the task of adjusting to fit the new categorised as a non complex instrument if it regulation. It is not just a question of the fund fulfils all the criteria in Article 38 of the Level 2 managers’ regulation, it may be that the fund Directive. CESR is of the opinion that the fact structure will need to change markedly. There there is a non UCITS investor in derivatives or in therefore could be reverse engineering achieved by other types of complex instruments will not the Commission of the soundness of the automatically make units or shares in the governance arrangements for the offshore undertaking itself complex for the purposes of the appropriateness test”; domiciled funds. A key question is whether this will be required only to benefit from the passports or • there are proposals on the establishment of a whether it is required if there is to be EU based fund new European body to oversee the stability of management. the European financial system pursuant to the De Larosière Report of February 2009. A consultation was issued on 27 May. Legislative 12
  13. 13. changes are anticipated in the autumn, with a • improve liquidity and risk management policies; view to it being up and running in 2010; • impose requirements for transparency, both to • the ongoing work on centralising the clearing of investors and regulators; and OTC derivatives and increasing the • improve the EU marketing possibilities, so that transparency of derivatives and complex there is effectively a private placement regime financial products will affect markets and for professional investors across the EU. products in which some alternative fund managers are major investors. Note that draft There is however considerable work to be done to recommendations to central counterparties refine the terms of the draft Directive to fit the were published by the European Central Bank realities of the structures of existing alternative (Euro System) and CESR joint Consultation investment funds. Whilst there is every reason to Paper issued on 31 March. wish to improve the governance arrangement for This wider package of reforms will of course have alternative investment funds, this should be done in further wide ranging effects on fund managers and a way which accepts the basis of their existing how they organise their activities. constitutions, so that existing funds can adapt rather than be replaced. The second point to note is that we cannot view the current changes as simply an EU set of proposals. One unexpected concern though which arises from It was specifically mentioned in the Commission’s this proposal is that it covers such a wide range of draft Directive proposals that its initiatives do not alternative funds, which is not really a cohesive body preclude wider international activity. In this regard, of funds. The constitution of these, and their the IOSCO Consultation Report on Hedge Funds respective perceived ills, vary tremendously, for Oversight, which was published in March 2009, may example from hedge funds which are highly be of interest. Their preliminary conclusions and leveraged to property funds with illiquid investments possible recommendations state that it is very and redemption issues. There is a risk that, by important to emphasise that any regulatory trying to cover such a wide range of funds, either the measures or standards need strong collective global proposals will be too high level or that they will miss action and application – as the hedge fund industry the mark for one or more particular types of funds. is highly global and mobile. The same could be said of most alternative investment funds. Again, their The second key unexpected concern is the severity proposals are not new. Look for example at the of the impact which the proposals would have for Recommendations from the Report of the Working depositaries. If depositaries were to increase their Group on Highly Leveraged Institutions in 2000 and fees to reflect their additional roles and consequent the subsequent IOSCO Reports. Fund Managers, potential liabilities – or indeed if some depositaries many of whom operate internationally are subject to were simply to refuse to take on the depositary role various regulations and regulators’ initiatives, will no for certain types of funds, this would be a retrograde doubt have a wide variety of new proposals with step. which to deal in the forthcoming months and years. Also we should be careful not to have unrealistic So, subject to these two points, and looking for the expectations of the proposals. As mentioned at the moment at simply the European proposals within beginning of this paper, proposals for new the European space, will they make a difference? regulations cannot cure all the perceived ills of some types of alternative investment funds nor remedy the If one takes as the starting point that the risks financial system’s recent failings. involved with alternative investment funds were underestimated and not sufficiently addressed, this package of requirements could improve matters overall for the bulk of authorised investment funds. It should: • ensure the capability of fund managers and their appointed administrators; 13
  14. 14. Appendix Glossary of terms Various of the provisions can be misread or misconstrued if we assume our usual interpretation of certain standard terms of art. The following terms therefore take some of the explanation of acronyms from Annex 1 of the Impact Assessment for this proposal for a Directive and then comment on how they fit with our usual definitions in the UK: Definition Explanation AIF alternative investment fund Note that, under the Proposal, this covers all non UCITS schemes. See the details below of the “NHF” or “non harmonised funds” which could be caught by this Proposal. AIFM entities engaged in the management and administration of alternative investment funds Note this therefore focuses on fund managers but the precise scope is unclear in the draft Directive. “CIS” or “collective arrangements that enable investors to pool their assets and have these investment scheme” professionally managed by an independent manager Note this is not as specific as the definition of collective investment scheme for example for UK purposes which is set out in section 236 of FSMA - it could be much wider. “closed ended funds” investment funds with restrictions on the amount of shares the fund will issue Note this is not as sophisticated as our closed ended investment company definition which is investment companies which are not open ended investment companies as defined in section 236 of FSMA with its property condition and the investment condition. Also, note that it could cover funds constituted in any particular way, whereas we differentiate closed ended corporate vehicles. “NHF” or “non investment funds that do not benefit from the EU passport of UCITS because they harmonised funds” do not comply with provisions of that Directive Note that non UCITS fund are much wider than alternative investment funds, and so the Directive should perhaps be re-named to make this clear. In Annex 2 of the Impact Assessment, the Commission identify the following categories of non harmonised funds (non UCITS): − French occupational funds, by which they appear to mean French employees’ savings funds; − UK trusts, by which they appear to mean British investment trusts; − special/institutional funds, by which they seem to mean a range of special/ institutional funds which exist in many Member States and take various legal forms but are not limited to a specific asset class or investment strategy and cannot therefore be attributed to a particular fund type; 14
  15. 15. Definition Explanation − hedge funds; − private equity funds; − real estate funds; − Luxembourg Part II funds; and − other (presumably to include Dublin non UCITS funds and UK non UCITS funds?). When looking at main constituents by way of investment of characteristics, they identify: − real estate funds; − private equity funds; − hedge funds; − funds of alternative investment funds (whether funds of hedge funds real estate funds or private equity funds or main non UCITS funds of funds); − commodity funds; and − infrastructure funds. open ended funds investment funds where the number of units/shares in issue increases as more people invest and decreases as people take their money out Following on from the comment on the definition of closed ended funds above, this is quite a straightforward distinction between open ended and closed ended funds and does not differentiate between the types of structure for these vehicles. UCITS undertakings for collective investment in transferable securities: EU regulated retail investor funds Note that of course UCITS no longer invest solely in transferable securities. Also, although UCITS certainly are retail funds, there are of course other retail investor funds available in the EU. This term UCITS is therefore of itself now doubly confusing and, if it were not for the UCITS brand, perhaps we should replace “UCITS” with some new term which communicates that they are EU passportable retail investor funds? leveraged alternative For the purposes of Chapter 5 of the proposed Directive, there are additional investment funds obligations for a fund manager managing a leverage alternative investment fund. Alternative funds shall be deemed to employ high levels of leverage on a systematic basis where the combined leverage from all sources exceeds the value of the equity capital of the fund in two out of the past four quarters. 15
  16. 16. Contact Kirstene Baillie Partner e. t. +44 (0)20 7861 4000 Field Fisher Waterhouse LLP 35 Vine Street London EC3N 2AA t. +44 (0)20 7861 4000 f. +44 (0)20 7488 0084 This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. © Copyright Field Fisher Waterhouse LLP 2009. All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Solicitors Regulation Authority. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word “partner” to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications.